The extension of credit is a principal financial underpinning to viable contemporary economic models. The extension of credit may be performed either by businesses that produce and sell goods or services, or alternatively, by financial institutions. Credit may be extended to either consumers or commercial entities. The American Collectors Association (“ACA”) currently estimates the amount of U.S. consumer debt to be at $6.3 trillion and growing.
Regardless of the source of financing, inevitably some portion of all credit granted results in delinquency and default. Delinquent receivables, for example, are generally considered to be any type of extension of consumer or commercial credit for which the debtor has failed to satisfy its obligations under a payment agreement with the credit grantor. Eventually, some portion of all delinquent receivables become classified as uncollectible and are charged against, i.e., deducted from, credit grantors' financial loss reserves or income statements. Receivables reaching this status are commonly classified as “charged-off” or “written-off” debt.
To absorb the cost of bad debt and limit credit losses, credit grantors must either impose restrictive credit guidelines on all debtors, and/or raise interest rates on credit, and/or raise prices on goods and services. The ACA estimates that bad debt costs every adult in the United States more than $680 per year. Since there is a limit on how high prices or interest rates can be increased before credit grantors begin losing customers, tightening credit guidelines or raising prices or interest rates are typically credit grantors' last resort. Instead, up to the point where it is no longer cost-effective, credit grantors typically try to exhaust a number of different debt collection and recovery methods, beginning with their own internal collection efforts.
The collection of delinquent receivables is a process that typically begins with the credit grantor's own efforts. The intensity of this collection effort depends upon the availability of internal resources. Small credit grantors are limited in this effort by their financial and human resource constraints. Larger credit grantors tend to centralize collection of delinquent receivables in specialized departments. Here, specialists, legal resources and rigorous procedures are combined to enforce debtor performance, restructure payment agreements or, when receivables are secured by collateral, repossess and pursue deficiencies.
Regardless of the size of the credit grantor, most consider it a core duty to pursue the full collection of delinquent receivables, but often find it difficult to justify the expense of extensive collection efforts. The operational collection and carrying costs of such receivables can be high, and may include personnel costs; holding period costs of funding; reserve and capital coverage costs; external resource costs; direct carrying costs such as for collateral pending disposition; and indirect carrying costs including accounting, management time and examination costs. In some cases, receivable balances may be too small to be afforded the aggressive attention required to maximize internal collection results. In other cases, simple gaps in the knowledge and tenacity of the credit grantor can limit collection efforts. But in all cases, 100% collection of delinquent receivables is rarely, if ever, internally cost-justified.
After exhausting internal collection efforts, most credit grantors find it necessary, in complying with Generally Accepted Accounting Practices (GAAP) and/or controlling government regulations, to deem the receivable to be uncollectible and to charge the delinquent receivable off its books. At the time of charge-off, the credit grantor may elect to (1) continue to pursue its own internal collection efforts, (2) place the account for collection with a third party collection or legal firm, (3) sell the receivable, or (4) cease all further collection efforts.
While other options exist, usually the credit grantor's first step following charge-off is to employ a third party collector. Third party collectors are granted the right to collect on behalf of the credit grantor in return for the right to retain a specified percentage of the money collected. Compensation paid to the third party collector is therefore contingent upon and directly proportional to the success of the collector. Since third-party collection services often use specialized phone systems, computers and software designed specifically for the collection industry, they are often more effective than credit grantors at retrieving payment on delinquent accounts. Typical contingent collection agreements between the credit grantor and the collector specify compensation arrangements, standards of work effort, and the term of the agreement.
The initial third party collector to receive the charged-off receivable from the credit grantor is called a “primary collector.” If the primary collector does not succeed in collecting the delinquent receivable by the end of the term of the agreement, the receivable is returned to the credit grantor. Upon receipt of the returned delinquent receivable, the credit grantor may elect to (1) pursue its own internal collection efforts, (2) place the account again for collection with another third party collection or legal firm, (3) sell the receivable, or (4) cease all further collection efforts. Should the credit grantor place the delinquent receivable with a subsequent third party collector, this collector is called a “secondary collector.” Secondary collection arrangements are similar to primary arrangements in that they specify compensation arrangements, standards of work effort, and the term of the agreement. Should the secondary collector be unsuccessful at its efforts, it is common for a delinquent receivable to be placed with a third consecutive, i.e., tertiary, third party collector or, even a subsequent fourth consecutive collector if the third collector is unsuccessful.
As described above, receivables may be in a variety of forms. That is, “receivables” as used herein may include, but not be limited to, charged-off consumer receivables, charged-off commercial receivables, delinquent consumer receivables and/or delinquent commercial receivables, for example. Further, it should be appreciated that receivables may be a hybrid of these respective types of receivables, for example. That is, “receivables” as used herein may include unpaid credit with some characteristics of delinquent receivables and some characteristics of charged-off receivables, for example. In addition, it should be appreciated that “receivables” as used herein may take the form of other unpaid credit not specifically described herein.
At any point throughout the receivable collection process, another option for the credit grantor is to sell the receivables. While the sale of receivables has been in existence for years, the evolution and development of a tangible and growing marketplace with significant numbers of institutional sellers and buyers began in the early 1980's with the federal government's wholesale liquidation of insolvent banks and their receivables portfolios. When at least one notably large banking institution conducted a sale of charged-off credit card receivables in 1989, healthy and solvent financial institutions began to recognize that receivable sales represented a viable alternative to their traditional reliance on third party contingent collectors. While there is no governmental or industry repository of sales volume statistics, most trade publications estimate current sales of receivables to exceed $40 billion per year, up from less than $1 billion in 1990. These figures represent the total of individual outstanding delinquent or charged-off balances at the time of sale. Portfolios of receivables offered for sale can range in size from less than one hundred thousand dollars to over one billion dollars in aggregate balances.
Sellers may be the original credit grantors, or alternatively, they may be buyers that are selling receivables acquired in previous purchase transactions. In either case, receivables are sold for a variety of financial and operational reasons. The seller may determine that (1) it can realize a better financial return from a sale than from the process of employing one or more consecutive third party collectors, or (2) it prefers receiving cash in a lump sum at one time rather than receiving smaller incremental amounts from a third party collection process that may take years to complete, or (3) it determines that the sale of receivables will enable it to reduce its own collection overhead, or (4) its own inventory of receivables has increased via merger or rapid growth at a pace beyond its own internal collection capability, or (5) many buyers rely on their ability to immediately sell smaller subsets of acquired portfolios' receivables to other buyers. This disposition process, also known as “reselling”, enables the original buyers to recapture part or all of their initial purchase capital and to dispose of certain subsets of portfolios that do not fit well into their standard collection processes. Reselling works well for both parties to the transaction because secondary buyers may either find more value per account in a subset than they did in an entire portfolio, or they may lack sufficient capital to purchase an entire portfolio themselves.
Buyers of receivables, like third party collectors, typically are specialists at collection. Buyers may themselves be third party collectors, or other credit grantors that have developed very efficient collection departments, or they may be collection law firms, or companies whose primary business is purchasing receivables.
Buyers purchase receivables for a variety of financial and operational reasons that may make them more successful at collection than a seller or a seller's third party collectors. For example (1) the buyer may have superior collection cost efficiencies such as a lower collection cost per account or lower cost of capital than the seller or the seller's third party collectors, or (2) the buyer may be able to offer more attractive incentives to delinquent debtors to pay off their debt than originally permitted by the seller, or (3) the buyer's collection period time horizon may be longer than either the seller's, or the time frame of a contingent collection arrangement between the seller and its third party collector(s), or (4) the buyer may employ collection techniques that, while more effective, are not permitted by the seller due to public relations concerns.
There are two general “transaction types” commonly used for the sale of receivables. These two transaction types include a “bulk” sale process and a “forward flow” sale process. In either transaction type, the seller may combine many individual receivables into a portfolio (“portfolio”) composed of receivables with similar characteristics. The grouping of receivables into portfolios may be based upon characteristics such as credit type, collection history, geography, or age of delinquency, for example.
The bulk sale transaction type is by far the most prevalent type used in the marketplace and involves the aggregation of individual receivables over months or even years, i.e., during a “holding period,” by the seller in anticipation of a single discrete portfolio sale event. Typically, immediately following the aggregation of receivables, the bulk seller solicits offers from potential buyers in a process, i.e., a “marketing process,” that can last from one to 90 days under known practices. Immediately following the seller's receipt of an acceptable purchase offer, the delivery of the portfolio by the seller occurs simultaneously with funding by the buyer.
The forward flow sale transaction type is much less prevalent in the marketplace and involves an agreement between buyer and seller that the seller will deliver a consecutive series of receivables portfolios at future monthly, quarterly or even yearly predetermined dates. Unlike a bulk transaction involving the sale of receivables that exist at the time of sale, a forward flow sale enables the seller to establish a mandatory price for its anticipated receivables, i.e., receivables that may not exist at the time of establishing the forward flow contract.
To explain further, the sale of a portfolio of receivables may be structured as a bulk sale transaction type or a forward flow transaction type. However, the method by which a sale portfolio is offered into the marketplace may be referred to as the “marketing process”, and may be used with either transaction type. The marketing process may include a competitive bid process, a request for proposal (“RFP”) process, or a private negotiation process with an individual buyer or buyers, i.e., a “private placement,” or utilization of a third party exchange or clearinghouse. While a seller typically initiates a marketing process, it should be noted that a buyer may initiate a purchase involving either transaction type via private negotiation or other methods with a seller.
In general, known marketing processes involve (1) some level of preparation of data pertaining to the portfolios of receivables, (2) communication of such data to one or more potential buyers, and, if successful (3) offers made by one or more potential buyers to purchase the subject portfolios.
In known processes and regardless of the process for receipt and consideration of offers, buyers' offers containing the highest price and the fewest contractual contingencies typically qualify for acceptance by sellers. The price is the amount of money a buyer is willing to pay a seller for the portfolio of receivables.
It should be appreciated that while the specific steps involved in marketing and selling bulk or forward flow transaction types may vary depending upon the specific methods employed by the seller, invariably the essential components of either type of sale include (1) an irrevocable agreement specifying performance between the seller to sell and the buyer to purchase, (2) the identification of a discrete portfolio of receivables in a bulk sale transaction type, or alternatively, the characteristics of a future portfolio in a forward flow delivery transaction type, (3) a fixed price, and (4) a delivery and funding time frame.
Further, it should be appreciated that, while principals to the transactions as described above are the sellers and buyers, i.e., the grantors and the grantees, respectively, brokers also often participate. That is, brokers often serve as intermediaries and can represent either sellers or buyers.